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Most of the time an increase in your tax bill reflects an increase in your income. Perhaps you earned a big raise or a bonus or even won the lottery. The tax bite may take some joy out of your celebration but you certainly come out ahead.

Foreclosure of your home, on the other hand, rarely causes anyone to celebrate, yet could result in similar tax consequences, in this case adding insult to injury.

The problem is that the Internal Revenue Service considers cancellation of debt to be equivalent to income. The way they look at it, if someone gives you $1,000 but says you have to pay it back, you have not gained anything. But if the lender calls you the next day and say never mind paying it back, you just made $1,000. So from the viewpoint of the tax-collecting agency, being foreclosed is just like coming into money, since you do not have to pay back the loan. Strange, but true.

Fortunately, in response to the housing crisis, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007, which has been extended through the end of 2013. The act allows homeowners to exclude from their income the reduction or elimination of debt due to foreclosure or mortgage modification. A few things to be aware of:

  • The exclusion only applies to a primary residence and only during the years 2007 through 2013.
  • The loan balance must be $2 million or less ($1 million for a married person filing a separate return).
  • The lender will provide you with form 1099-C, Cancellation of Debt, showing the amount of debt forgiveness and you must report that amount on your taxes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.
  • If the foreclosure occurred in conjunction with bankruptcy, the discharge of mortgage debt is probably already excluded from income.

The best outcome, of course, is to avoid foreclosure in the first place. Contact a knowledgeable Tampa foreclosure attorney to learn what options are open to you.

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